As many of you know, the United States Department of Treasury and Internal Revenue Service are looking into the possibility of greater regulation of tax preparers. While this article does not address non-regulated tax preparers or preparers who do not have basic competencies in preparing tax returns, it addresses two unintentional pitfalls that even the most conscientious preparers might meet: Failure to adequately review client information while preparing tax returns and misunderstanding whether an undisclosed tax return position must meet a "substantial authority" or "more likely than not" threshold.

IRC 6694(a)(1) provides that if a tax preparer takes an unreasonable position on a tax return that results in an understatement of tax, he or she can be subject to a penalty equal to the greater of $1,000 or 50 percent of the fee the preparer received for preparing the return. IRC 6694(a)(2) states the general rule that an undisclosed return position generally does not constitute an unreasonable position if the position meets the substantial authority standard set forth in IRC 6662. There are two exceptions to this rule. First, a disclosed return position is not unreasonable if there is "reasonable basis" (generally viewed as a one in three likelihood of being correct) for taking the position on the tax return. Second, if the undisclosed return position involves a tax shelter (as defined in IRC 6662(d)(2)(C)(ii)), the preparer is subject to the IRC 6694 penalty unless the preparer has a reasonable belief that the position is more likely than not to be sustained on the merits.

The Treasury Regulations under IRC 6694 make it clear the preparer can generally rely on the information provided by the client in preparing the return without verification and by doing so, not be subject to the penalty regime. See Treasury Regulation Section 1.6694-1(e)(1). However, meeting this general requirement does not always let the preparer off the hook. First, the Treasury Regulations under 6694 that govern the reasonable cause standard provide that a preparer must have normal office procedures in place that elicit the right information to prepare tax returns and "generally would include, in the case of a signing preparer, checklists, methods for obtaining necessary information from the taxpayer, a review of the prior year's return, and review procedures." Treasury Regulation Section 1.6694-2(e)(4). Second, the preparer must not ignore the implications of the information given to him or information actually known by the preparer. Furthermore, the preparer must make reasonable inquiries if the information presented is incomplete. Finally, if the IRS requires that certain documentation be kept in order to take certain deductions (such as travel and entertainment), the preparer must make inquiries that the proper documentation does indeed exist. See Treasury Regulation 1.6694-1(e)(1).

Based on these Treasury Regulations, it is clear the IRS does not expect tax preparers to audit client information in order to avoid preparer penalties. However, the IRS does expect preparers to have appropriate checklists for different types of clients. The IRS appropriately expects preparers to elicit information from taxpayers that would be reasonably necessary to prepare a tax return. In other words, the IRS does not expect the preparer to merely accept the information given to her by the client. Rather, the IRS anticipates the preparer will review the information given by the client, compare that information to a checklist or some other written procedure and ask the client for additional information if necessary for the preparer to complete a professional tax return.

Thus, the IRS does require the preparer to be proactive in terms of asking for the right information necessary to prepare tax returns, even if it means the preparer will need to spend more time with the client during the preparation process. Asking the appropriate questions will keep the preparer out of the penalty box. However, Section 6694 penalties can and will be imposed on preparers who fail to make reasonable inquiries of their clients during the preparation process.

Expanded Interpretation of Tax Shelter for Disclosure Purposes

As stated above, a non-disclosed tax return position involving a "tax shelter" can result in a preparer penalty unless the preparer has a reasonable belief that the position will more likely than not sustained on the merits. IRC Section 6662(d)(2(C)(ii) defines a tax shelter as a "(I) a partnership or other entity, (II) any investment plan or arrangement or (III) any other plan or arrangement, if a significant purpose of such partnership, entity, plan or arrangement is the avoidance or evasion of Federal income tax."

Practitioners generally associate the phrase tax shelters with marketed tax products involving aggressive tax positions. However, the plain language of the Code does not refer to marketed tax products or even overly aggressive tax positions. Rather, a tax planning technique is deemed a tax shelter if a significant purpose of the planning involves the avoidance or evasion of Federal income tax.

While garden variety tax planning techniques are not subsumed by the tax shelter exception, the recent case of Valero Energy Corp. v. United States, 103 AFTR 2d 2009-2683 (7th Cir June 17, 2009) provides important insight into what is or isn't a tax shelter. According to the Seventh Circuit, the tax shelter definition is unambiguous and encompasses any plan whose significant purpose was to avoid or evade Federal income taxes even though the court acknowledged such a reading of the Code could include legitimate attempts by a person to reduce its tax burden. The court further noted that the concept of tax shelter went far beyond tax strategies that were actively marketed by a third party.

The impact of Valero on IRC 6694 penalties is not yet clear. Nevertheless, in light of Valero, a preparer ought to think long and hard about taking an undisclosed position on a tax return, even if he has a reasonable belief that substantial authority exists for such position, if such position involves a new or novel interpretation of the Code and involves significant tax savings. In such cases, it is entirely possible the IRS will assert that the tax planning involved a tax shelter and, if the taxpayer's position was undisclosed and not ultimately sustained, may result in the imposition of an IRC 6694 penalty on the preparer.

Conclusion

In summary, the preparer community must meet professional standards in terms of eliciting the requisite information to enter into tax returns. Moreover, preparers should consider disclosing any aggressive tax planning tax return positions in order to avoid the headache of possibly defending against the assertion of IRC 6694 penalties by the IRS.

Larry Jacobson, an attorney and CPA, is a senior partner in the Chicago office of the law firm of Schiff Hardin LLP. He holds a BA from Washington University, an MBA from the University of Chicago, an MSOD from the University of Pennsylvania and a JD from the Georgetown University Law Center.